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Understanding Futures Contracts for Hedging

May 22, 2025

Derivatives Fundamentals and Options Licensing Course: Hedging with Futures Contracts

Introduction

  • Purpose: The primary function of a futures market is to enable risk-averse participants to hedge against price risks by shifting these risks to speculators who are willing to assume them for potential profit.
  • Hedging vs. Speculating: Hedging is about reducing or eliminating risk, while speculating involves assuming risk for potential profit.

Key Concepts

  • Hedging: Attempting to reduce or eliminate price risk in the market.
  • Types of Hedges:
    • Short Hedge: Protects against declining prices if you own or anticipate owning an asset.
    • Long Hedge: Protects against rising prices if you anticipate buying an asset.
  • Basis Risk: The risk that the difference between the spot price and futures price (basis) will change unexpectedly.
  • Optimal Hedge Ratio: A calculation to determine the number of futures contracts required to hedge effectively.

Short Hedge

  • Definition: Used by those who own or expect to own an asset and wish to protect against price declines.
  • Example 4.1: A farmer hedges 1,000 tonnes of canola by selling futures contracts to lock in a selling price, eliminating risk from price drops.

Long Hedge

  • Definition: Used by those who expect to buy an asset and wish to protect against price increases.
  • Example 4.2: A dental supply company buys futures to hedge against potential price rises in silver, locking in a purchase price.

Perfect vs. Imperfect Hedges

  • Perfect Hedge: When the basis behaves as expected, resulting in the hedger knowing the net price outcome.
  • Imperfect Hedge: When the basis behaves unexpectedly, leading to potential unexpected costs or losses.
  • Example 4.3: A hedge becomes imperfect due to unexpected market events that change supply-demand dynamics.

Cross-Hedging

  • Definition: Using a futures contract of a different but correlated asset to hedge.
  • Examples:
    • Financial Markets: Using CORRA futures to hedge against interest rate changes.
    • Commodities: Using wheat futures to hedge against flour price changes.

Optimal Hedge Ratio

  • Purpose: Minimizes basis risk by adjusting the number of contracts according to historical or expected price relationships.
  • Calculation:
    • Formula: ( H = \text{Corr}_{PF} \times (\text{SD}_P / \text{SD}_F) )
    • Example 4.5: Calculating optimal hedge ratio for a jet fuel scenario using heating oil futures._

Conclusion

  • Hedging Strategy: It is essential to understand the risks involved and the measures to minimize basis risk, such as using the optimal hedge ratio.
  • Practical Application: Proper hedging requires careful consideration of market conditions, asset correlations, and the nature of the futures contracts.

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